Background

The internet is becoming an ever greater part of our lives. This trend is likely to accelerate as developing countries around the world extend web-access to an ever-increasing population.

As familiarity grows, internet-savvy consumers are becoming more discerning. Any business that wishes to attract customers must have an appealing website. There is a boom in demand for web-development and creative skills.

Just as the pick and shovel makers were the real winners during the gold rush, the companies that supply developers with the tools to produce the coolest web sites will be the big winners in the internet age.

It became evident that Google was going to be a runaway success when the name become a verb. And it is another verb spawned by the new economy that underpins the case for Adobe Systems.

How often do we hear comments like:

‘Don’t worry about the background – we’ll photoshop it.’

or

‘Is she real in that picture – or has it been photoshopped?’

Photoshop is part of a suite of products that Adobe calls ‘Creative Cloud’. In addition to Photoshop, the Creative Cloud suite comprises a number of leading edge design tools that dominate the market to the extent that they have become essential requirements for web developers .

Creative Cloud is produced by Adobe’s Digital Media business unit. There are two more business units: Digital Marketing and the legacy Print and Publishing segment. Digital Media represents 70% of the business, Digital Marketing 28% and Print and Publishing represents the 2%.

The Digital Media business grabs most of the attention, but the Digital Marketing business is a valuable asset.

The Digital Marketing division provides solutions and services for digital advertising campaigns. New social media services are gradually replacing many of the information and entertainment platforms traditionally tapped by advertisers. Adobe’s Digital Marketing division provides a route that enables businesses to adapt to these new platforms.

The Transition

A few years ago Adobe sold its products under a permanent software license. Under this model customers make a single payment in order to license the software in perpetuity. The software producer would then hope to gain further income by offering a maintenance and support agreement.

In common with many other software suppliers, Adobe decided to transition their business to a subscription model. Under this arrangement the purchaser pays a smaller amount regularly. The customer’s license to use the software terminates when the subscription ceases. While the subscription continues the customer is guaranteed access to the very latest features as soon as they are released.

The subscription model provides less cash up front to the software producer, but is far more lucrative over the lifetime of the relationship with the customer.

Transitioning to a subscription based model can be a painful time for software companies. The loss of large up-front payments is detrimental to cash flow. In the third quarter of 2016 recurring revenue represented 83% of Adobe’e total revenue. This indicates that the company has successfully made the transition to a subscription model and can look forward to a period of sustained, even growth.

Financials

With gross margins of around 85% and net margins of around 30%, Adobe has a very powerful business model. The company has continued to exhibit strong growth of around 20% over recent years.

Management

Adobe’s management team is led by Shantanu Narayen (Born 1963). Narayen has been CEO since 2007. He has been named a “Top Gun” CEO by Brendan Wood International and in 2011 President Obama appointed him as a member of his Management Advisory Board.

Keen, intelligent and optimistic, Narayen is a CEO that inspires confidence. On Adobe’s web site you can hear first hand Narayen’s authoritative and assured handling of the issues and questions on the latest earnings conference call.

Problems and Pitfalls

With a historically high P/E value, Adobe’s shares are not cheap.

The combination of a high valuation and a management prepared to forego short term gains for a long term return often leads to a volatile share price.

There is always a possibility that a new entrant to the market with better products at competitive prices could mount a serious challenge to Adobe.

The Bottom Line

Adobe is unquestionably the market leader in the area of creative graphics. The company made the right decision to move to a subscription-based model and it’s top quality management team has executed flawlessly in achieving this transition while maintaining the company’s market dominance.

With the demand for creative tools growing like gangbusters, there is a huge runway for growth for the company’s products, which is unlikely to abate anytime soon as developing countries around the world transition their economies to the cloud.

Warren Buffett says that he’d rather pay a fair price for a great business than a great price for a fair business.

Adobe is the epitome of a great business, and shareholders with a long term view can reasonably expect to achieve market beating returns well into the future.